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Student debt relief option: Instant gain, distant pain
January 4, 2012 (published)
Edie Lau
Editor's note: This is one in a periodic series of articles examining the complex and escalating issue of higher-education debt and how it affects the veterinary community.

Picture this: Ever since you were a kid you wanted to be a veterinarian. You excelled as an undergraduate, made it into veterinary school, survived four more years of education and now, even in a difficult economy, you’ve landed a job. The bad news? You owe $142,000 plus interest on student loans.

Under the standard 10-year payment plan, you’re on the hook for $1,634 each month. With a yearly income of $70,000 as an associate veterinarian in private practice, that’s a sizable chunk — 28 percent of your gross income, and even more of your take-home pay. You’ve made it into your dream profession and the work is great, but you’re still scrimping like a student with no promise of relief ahead.

For a rising number of young veterinarians, this is not a hypothetical scenario. It’s real life. Nine out of 10 veterinarians who graduated this spring owe money on their education, and their average debt is $142,613, according to an analysis published in the Oct. 1 edition of the Journal of the American Veterinary Medical Association.

Meanwhile, finding a job is difficult and entry-level pay has sagged: the average full-time starting salary is $66,469. (This figure does not account for the lower wages of graduates pursuing advanced education.)
The situation is not unique to veterinary medicine. Although new veterinary students may have extreme debt-income imbalance, spiraling debt has become a critical issue throughout higher education. That has prompted a variety of government programs to try to ease the pain. Among the options, the program that student-debt specialists believe may be helpful to the greatest number of strapped borrowers is known as Income-Based Repayment, or IBR.

Authorized in 2007 under the College Cost Reduction and Access Act and first available in 2009, IBR enables borrowers of government-backed student loans with high monthly payments and relatively low incomes to reduce those payments to 15 percent of their discretionary income. The period for repayment may extend as long as 25 years and any balances remaining after 25 years are forgiven.

In the case of a veterinarian owing $142,000 and earning $70,000 a year, IBR could knock down her monthly obligation to $633. That’s $1,001 less than the payment under the 10-year plan.

Sound good? IBR clearly is a useful tool for managing monthly expenses, and a godsend for those otherwise at risk of default. But IBR is not without pitfalls.

With an extended repayment period, participants end up paying more interest. Moreover, in the case of borrowers whose reduced monthly payments cover only some of the interest owed and none of the principal, loan balances rise rather than shrink. If their incomes do not grow appreciably, enabling them to make substantially larger monthly payments, after 25 years they could wind up owing more than when they graduated.

What’s more, under current law, those whose balances are discharged after the repayment period will be taxed on that balance. With a few exceptions, U.S. tax code treats forgiven loans as income. If the sum forgiven is large, the tax hit could be significant — potentially tens, even hundreds, of thousands of dollars.

Models examine IBR over the long haul

Concerned about how the future may play out for student borrowers, independent organizations have begun examining the eventual implications of using IBR. One such organization is the VIN Foundation, a non-profit corporation whose mission is to support the long-term viability of the profession.

(The VIN Foundation shares leaders and philosophy with the Veterinary Information Network, a private company that operates an online community for the profession and the VIN News Service. However, the foundation and VIN are separate legal entities.)

The foundation, in consultation with other individuals and groups interested in the student-debt question, modeled several scenarios under IBR. The models show that immediate relief for the borrower may come with a hefty price tag over the long term.

One scenario shows that a borrower with a starting annual salary of $70,000 that grows by 1 percent a year and who uses IBR to pay for a loan of $142,000 with an interest rate of 6.875 percent will see the loan balance grow steadily. In 25 years, the balance reaches $188,562. That sum would be forgiven, then taxed.

Assuming a marginal tax rate of 30 percent on the forgiven balance, the borrower would owe $56,569 in income tax. By that point, the borrower already would have paid $195,969, which brings to $252,538 the total payments and associated taxes on a $142,000 loan (not including any state tax that may apply).

Though the government taketh away, it giveth somewhat, as well: Current tax law permits taxpayers with taxable income of $60,000 or less — or $120,000 if filing a joint return — to deduct $2,500 in student-loan interest payments each year. Filers need not itemize to take the deduction. Were the deduction to be available every year for 25 years — which is far from assured — it would be worth $15,625 to a borrower who is continuously eligible for the maximum deduction, assuming the borrower’s marginal tax rate is 25 percent.

A second IBR scenario modeled by the VIN Foundation assumes the borrower’s salary grows by an average of 3 percent each year over the period. In this case, the borrower manages to pay down the loan balance to $89,759. Forgiveness of that balance would bring an income tax bill of just under $27,000, again assuming a 30-percent marginal tax rate.

That borrower would have paid $282,238 on the $142,000 loan. With taxes, the grand total would be $309,166.

The average annual income growth rates of 1 and 3 percent are based upon historical income increases experienced by veterinary associates and clinic owners, respectively, according to Dr. Alejandro Garcia, a member of the team working on the VIN Foundation models. Garcia said the rates are based on income figures reported in surveys conducted over the years by the American Veterinary Medical Association. Those surveys showed associates experiencing a yearly average growth in pay of 1.24 percent and owners, 2.65 percent.

Dr. Paul Pion, president of the VIN Foundation and co-founder of VIN, said the models that assume $142,000 in loans may understate the situation because that figure is an average and does not include American students attending accredited veterinary programs in the Caribbean and elsewhere abroad. Some new and soon-to-be veterinary school graduates have or are amassing educational debts two and even three times that sum.

“It’s probably worse than we think,” Pion said.

He added that astronomical debts aren’t accrued because students are “living large,” but because the cost of schooling keeps climbing. In the United States, tuition and living expenses for four years of veterinary school ranges from $121,481 at Oklahoma State University to $300,986 at Western University of Health Sciences in California. The range is based on in-state tuition; most schools charge non-residents more.

Pion calls IBR “a great short-term solution” that likely will prevent mass defaults by borrowers as happened in the housing-market meltdown.

The drawback he sees is this: “Like so many political things, it pushes the problem off to the future. What’s going to happen in 20 to 25 years when the tax payments come due?”

Some student-debt and tax advisers are confident that Congress will work out a solution before then, whether it be allowing borrowers to pay their taxes over an extended period or exempting the forgiven balance from tax. Pion does not share that confidence.

“I wouldn’t bet my future on that,” he said. “My advice would be for them to put aside money as they’re going along, to save money for that tax bill. And wouldn’t it be a nice thing if you had that saved and then the government forgave it?”

Congress is aware of the income-tax issue. Michigan Rep. Sander “Sandy” Levin has twice sponsored legislation to exempt IBR loan forgiveness from income tax. Levin is the ranking Democrat on the House Ways and Means Committee. Although the bills — one introduced in 2008, the other in 2009 —  drew bipartisan support, they did not pass out of committee.

Aides to Levin said they do not believe lawmakers’ current focus on cost-cutting is an impediment, since any budget impact of a tax exemption is two decades away. As to what an exemption might cost the Treasury, Josh Drobnyk, Levin’s communications director, noted that Congress makes no revenue projections beyond 10 years.

Meanwhile, the looming tax question may have the immediate effect of deterring some borrowers from taking advantage of IBR.

“We have heard that anecdotally,” said Levin’s senior economic adviser, Jeff Ziarko. For that reason, “Mr. Levin thinks it’s quite important to address this sooner rather than later,” Ziarko said. “The whole point is to make sure that students feel comfortable availing themselves of this option. The goal of the effort is to make the IBR program work better for more students.”

Some debt-relief programs have no tax hit

The law that established IBR also created a Public Service Loan Forgiveness program that has more generous terms, including a tax exemption. Under this program, borrowers with government-backed loans employed by government agencies (federal, state, local or tribal) or most charitable non-profit organizations, including academic institutions, are forgiven any remaining loan balances after making payments for 10 years. The forgiven sum is not subject to federal income tax.

Within veterinary medicine is another debt-assistance program in which the government covers the recipient’s income-tax bill. That program is the Veterinary Medicine Loan Repayment Program (VMLRP) run by the U.S. Department of Agriculture (USDA).

The program is relatively new and small in scope. Its first crop of awardees, selected in 2010, consisted of 62 practitioners. In fall 2011, awards were offered to another 80 veterinarians, according to Dr. Gary Sherman, national program leader for veterinary science at USDA’s National Institute of Food and Agriculture, which oversees the program.

Veterinarians selected for the VMLRP agree to work for three years in a region defined as having a shortage of veterinarians. In return, the government pays to each participant’s educational lender up to $25,000 each year on participants’ behalf.

The payments are taxable, but Congress specified that the program would cover all or part of the tax liability that resulted, Sherman said. So an awardee receiving the maximum $75,000 loan repayment actually costs the program $104,250, Sherman said; the USDA sends to the Internal Revenue Service on behalf of the participant a sum equal to 39 percent of the loan payment amount.

In a letter responding to questions from Congressman Levin in 2007, former Assistant Treasury Secretary Eric Solomon outlined the tax treatment of various government loan-payment assistance programs. In addition to the Public Service Loan Forgiveness program, tax exemptions apply to a loan-forgiveness program for teachers working in certain schools serving low-income families, according to the correspondence.

Despite the prospective tax burden and the increase in interest expenses that come with IBR, consumer advocates with expertise in student debt tend to like the program. One is Heather Jarvis, a lawyer who maintains a website with a wealth of information about educational borrowing. She calls IBR “an important part of promoting access to affordable education.”

“In my mind, what it boils down to is this,” Jarvis said: “If you have the money, you should definitely pay debt as soon as possible.”

“If you don’t have money and you need a reduced payment,” she went on, “then IBR is the best way to get it, as opposed to (other options such as) extended repayment, graduated repayment, deferments or forbearance.”

IBR is not the only program that allows extended repayment. Jarvis noted that heavy borrowers typically consolidate their school loans and secure longer periods for paying the debt. For balances over $60,000, she said, 30 years is standard.

However, such repayment schemes are comparable to mortgages in that the monthly payment is not tied to the borrower’s income, as it is with IBR.

Another feature of IBR is that unpaid interest does not capitalize, or get added to the principal, unless and until the participant is found to no longer have a “partial financial hardship.” If a participant’s income should rise to that point, then he or she will have to pay capitalized interest — in other words, pay interest on the interest.

As of Sept. 30, nearly 475,000 borrowers had been approved to participate in IBR, according to U.S. Department of Education spokeswoman Sara Gast. The department has no estimate of the number of borrowers that might qualify, Gast said.

In October, President Obama called attention to the student-debt problem by offering even better repayment terms to a subset of borrowers — those with federal Direct Loans. The initiative is dubbed Pay As You Earn. Referred to by the acronym PAYE, the program caps monthly loan repayments at 10 percent of a borrower’s discretionary income and reduces the payment period from 25 years to 20 years, after which the balance is forgiven.

In response to a query dated Oct. 27 from Rep. John Kline, R-Minnesota, chairman of the House Committee on Education and the Workforce, Secretary of Education Arne Duncan on Nov. 18 outlined the plan while noting that details are scheduled to be worked out in the new year.

One of Kline’s questions concerned the program cost. Duncan responded that the program overall is estimated to be cost-neutral and might even net $2 billion, owing to a provision allowing borrowers with a combination of federal Direct Loans and government-backed loans serviced by private lenders to consolidate those loans under the Direct Loan program, thereby saving the government the cost of subsidies it pays to private lenders.

Pion at the VIN Foundation noted that the ultimate cost and value of IBR to taxpayers and borrowers alike will be influenced by changes to the dollar’s worth over time. If significant inflation occurs, for example, a dollar 20 years from now will have considerably less buying power than a dollar today. That’s a good deal for a borrower allowed to pay over a longer stretch.

On the other hand, taxpayers are doing better than borrowers when it comes to the interest rate charged on federal student loans, Pion added. At 6.8 percent, it’s considerably higher than rates on 30-year mortgages, which are averaging below 4 percent.

The loan types aren’t directly comparable because mortgages are secured loans and student loans are unsecured; however, because student loans cannot be discharged through bankruptcy, Pion maintains that they are, in a sense, secured.

In general, Pion said he believes the debt-relief program is a good deal for U.S. taxpayers. “Our taxes help educate the electorate, and the money gets repaid to the Treasury in a way that hopefully was livable for the borrower,” he said.

Jarvis, for her part, said she believes the cost to taxpayers isn’t likely to be high, while the discharge of loan balances will be significant to borrowers who need it. She noted that only those who don’t earn enough over 25 years to pay off their loans will receive IBR forgiveness.

“It remains true overall that people with higher education tend to earn better salaries,” Jarvis said. She predicted, “Most student loan borrowers will be able to repay their debts and won’t need the safety net.”

Whether that will hold true for veterinarians and veterinary students who have borrowed heavily to finance their education is an open question. A rule of thumb for school debt is that it should not exceed the first year’s salary of a new graduate.

If that’s the case, the average veterinary-school borrower, with $142,000 in loans and a prospective average starting salary of $70,000, is graduating with more than twice the level of debt considered sustainable.